Adjusted estimated leverage ratio

What Is Adjusted Estimated Leverage Ratio?

The Adjusted Estimated Leverage Ratio is a measure of a financial institution's capital adequacy that takes into account certain modifications or estimations to its standard leverage exposure. This ratio falls under the broader umbrella of Financial Regulation, serving as a crucial tool within the framework of Banking System oversight to bolster Financial Stability. Unlike Risk-Weighted Assets calculations, which assign different capital charges based on the perceived riskiness of assets, the leverage ratio is a non-risk-based measure. It provides a simple, transparent backstop to ensure banks maintain a sufficient cushion of Tier 1 Capital against their total unweighted exposures, encompassing both on-balance sheet assets and certain Off-Balance Sheet items.

History and Origin

The concept of a simple leverage ratio as a regulatory backstop gained prominence following the 2008 global financial crisis. During this period, many banks had accumulated excessive on- and off-balance sheet leverage, often while maintaining what appeared to be robust risk-based capital ratios. The subsequent deleveraging process exacerbated the crisis, leading to significant damage to the broader financial system and economy. In response, the Basel Committee on Banking Supervision (BCBS) introduced a leverage ratio as part of the Basel III framework, with a minimum requirement initially set at 3% for internationally active banks. This measure was designed to complement risk-based capital requirements by restricting the build-up of excessive leverage. The full text of the Basel III leverage ratio framework and disclosure requirements was endorsed by the Group of Central Bank Governors and Heads of Supervision (GHOS) on January 12, 2014, and formally published by the Bank for International Settlements (BIS).¹³,¹²

In the United States, regulators subsequently introduced the Enhanced Supplementary Leverage Ratio (eSLR) for large, Systemically Important Financial Institutions (GSIBs), which often involves further adjustments or estimations beyond the core Basel III standard. For instance, recent proposals by U.S. banking regulators aim to modify the eSLR standards to ensure they function as a true backstop, rather than a primary constraint that might unintentionally discourage banks from engaging in lower-risk activities like intermediating U.S. Treasury markets.¹¹ This ongoing refinement reflects a commitment to appropriate calibration of regulatory requirements.¹⁰

Key Takeaways

• The Adjusted Estimated Leverage Ratio acts as a non-risk-based measure of a bank's financial soundness, complementing risk-based Capital Requirements.
• It ensures a minimum level of Regulatory Capital against total exposures, mitigating the risk of excessive leverage accumulation.
• Adjustments to leverage ratios, such as the Enhanced Supplementary Leverage Ratio (eSLR) in the U.S., are often debated and refined to optimize their function within the broader regulatory landscape.
• The ratio's simplicity provides a transparent view of a bank's overall leverage, reducing reliance on complex internal models that can be subject to "model risk."⁹

Formula and Calculation

The fundamental leverage ratio is calculated by dividing a bank's Tier 1 capital by its total leverage exposure. The "adjusted estimated" aspect typically refers to specific inclusions, exclusions, or methodologies applied to the exposure measure, particularly in the context of advanced regulatory frameworks or specific national implementations.

The general formula for the leverage ratio is:

Where:

• Tier 1 Capital represents a bank's core capital, primarily consisting of common equity Tier 1 capital and additional Tier 1 capital. It is the highest quality of capital as it is fully available to absorb losses.
• Total Leverage Exposure is the sum of a bank's on-Balance Sheet assets, plus specific add-ons for Derivatives exposures, Securities Financing Transactions (SFTs), and other off-balance sheet items, calculated according to specific regulatory guidelines.⁸ The methodologies for calculating these "add-ons" and the treatment of various exposures are where adjustments or estimations come into play.

Interpreting the Adjusted Estimated Leverage Ratio

Interpreting the Adjusted Estimated Leverage Ratio involves understanding its role as a safeguard rather than a primary indicator of risk. A higher leverage ratio generally indicates a more robust Capital Requirements buffer relative to total exposure, suggesting greater resilience to unexpected losses. Regulators typically set minimum thresholds for this ratio, and a bank's ability to maintain a comfortable margin above this minimum is often viewed favorably.

However, because the leverage ratio treats all assets equally, regardless of their inherent risk, a very high or binding ratio can sometimes lead to unintended consequences. For example, it might disincentivize banks from holding low-Credit Risk assets, such as U.S. Treasury securities, if the capital charge for these assets under the leverage ratio is disproportionately high compared to their risk-based capital charge. This dynamic highlights why adjustments to the leverage ratio, like those proposed for the eSLR, are important to ensure the ratio functions as an effective backstop without unduly constraining beneficial Economic Activity.⁷

Hypothetical Example

Consider a hypothetical bank, "Diversified Holdings Bank," which is subject to an Adjusted Estimated Leverage Ratio requirement.

• Scenario: Diversified Holdings Bank has Tier 1 Capital of $100 billion.
• Calculation of Total Leverage Exposure:
  • On-balance sheet assets: $2.5 trillion
  • Add-ons for derivatives (after accounting for cash variation margin and netting, as per adjusted rules): $150 billion
  • Add-ons for securities financing transactions: $50 billion
  • Other off-balance sheet items (after applying credit conversion factors): $100 billion

The bank's total leverage exposure would be:
$2.5 trillion + $150 billion + $50 billion + $100 billion = $2.8 trillion

The Adjusted Estimated Leverage Ratio for Diversified Holdings Bank would be:

If the regulatory minimum for this Adjusted Estimated Leverage Ratio is, for instance, 3%, Diversified Holdings Bank's ratio of 3.57% indicates it is meeting the requirement and has a modest buffer. This simple calculation provides a quick overview of the bank's fundamental leverage position without the complexities of Risk-Weighted Assets.

Practical Applications

The Adjusted Estimated Leverage Ratio finds its primary application in the realm of Financial Regulation and Banking Supervision. It is a key metric used by regulatory bodies, such as the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) in the U.S., to assess and enforce capital standards for banks.

Specifically:

• Regulatory Compliance: Banks must calculate and report their leverage ratio, often with specific adjustments mandated by national authorities, to ensure compliance with minimum Capital Requirements. This includes adherence to the Basel III framework and its national interpretations, like the Enhanced Supplementary Leverage Ratio in the U.S.⁶
• Macroprudential Tool: Beyond individual bank soundness, the leverage ratio serves as a macroprudential tool. By limiting excessive leverage across the Banking System, it aims to prevent the build-up of systemic risk that could destabilize the entire financial system.⁵
• Investor and Analyst Evaluation: While complex risk-weighted ratios are also important, the simplicity of the leverage ratio makes it an easily digestible metric for investors and analysts to gauge a bank's overall capitalization and capacity to absorb losses.

Limitations and Criticisms

Despite its benefits as a simple backstop, the Adjusted Estimated Leverage Ratio has faced certain limitations and criticisms. One primary critique is its non-risk-sensitive nature. By treating all assets uniformly, regardless of their inherent risk, the leverage ratio can create disincentives for banks to hold low-risk, high-liquidity assets like government bonds. For example, a U.S. Treasury bond is treated the same as a far riskier corporate bond in the leverage ratio calculation, even though their Credit Risk profiles are vastly different. This can potentially distort incentives and hinder the smooth functioning of certain financial markets, such as the U.S. Treasury market, particularly during times of stress.⁴

Furthermore, critics argue that an overly stringent leverage ratio could raise banks' funding costs, which might then be passed on to borrowers, potentially leading to less capital formation and reduced Economic Activity.³ While proponents argue that the benefits of a more stable financial system often outweigh these costs, the debate underscores the importance of calibrating the leverage ratio appropriately to avoid unintended consequences for financial markets and lending.² The reliance on specific "adjustments" also means that the ratio's exact definition can vary, potentially leading to complexities in cross-jurisdictional comparisons or even regulatory arbitrage if not carefully managed.

Adjusted Estimated Leverage Ratio vs. Supplementary Leverage Ratio

The Adjusted Estimated Leverage Ratio is often a nuanced version of, or directly related to, the Supplementary Leverage Ratio (SLR). The SLR, particularly in the United States, is a specific regulatory capital requirement that applies to larger banking organizations. It builds upon the basic leverage ratio introduced under Basel III.

The key difference lies in the "adjusted" or "estimated" component. While the core SLR framework defines the calculation of Tier 1 Capital against total leverage exposure, an "Adjusted Estimated Leverage Ratio" might refer to:

• Specific national or regional adaptations: Different jurisdictions may implement the Basel III leverage ratio with unique modifications to the exposure measure or capital definition to suit their domestic market characteristics and regulatory objectives.
• Temporary adjustments: Regulators might temporarily adjust the calculation of the SLR during periods of market stress, such as excluding U.S. Treasury securities and deposits at Federal Reserve Banks from the exposure measure, as was done in 2020 in response to the COVID-19 pandemic.¹
• Ongoing proposals for recalibration: Regulators continuously review and propose changes to the SLR framework to ensure it achieves its intended goal as a backstop without creating undue constraints on Liquidity Risk or market functioning. The "adjusted estimated" term, therefore, highlights these dynamic and specific variations or proposals that move beyond the static definition of the standard Supplementary Leverage Ratio.

FAQs

What is the primary purpose of the Adjusted Estimated Leverage Ratio?

Its primary purpose is to act as a simple, non-risk-based backstop to risk-based Capital Requirements for banks. It aims to prevent the build-up of excessive leverage in the Banking System and enhance financial stability.

How does it differ from risk-weighted capital ratios?

Unlike risk-weighted capital ratios, which assign different capital charges based on the perceived risk of assets, the Adjusted Estimated Leverage Ratio treats all exposures (assets and certain off-balance sheet items) equally in the denominator. This makes it a simpler, less complex measure.

Why do regulators make "adjustments" to the leverage ratio?

Regulators make "adjustments" to fine-tune the ratio's effectiveness, often in response to market conditions or to address unintended consequences. These adjustments aim to ensure the leverage ratio functions as an appropriate backstop without hindering banks' ability to engage in low-risk activities or support Economic Activity.

Is the Adjusted Estimated Leverage Ratio relevant to all banks?

While the fundamental leverage ratio concept applies broadly, specific "adjusted" or "enhanced" versions, like the Enhanced Supplementary Leverage Ratio (eSLR) in the U.S., often apply to larger, Systemically Important Financial Institutions (GSIBs) due to their potential impact on the wider financial system.